Income Inequality (30): A Primer on Inequality and Economic Growth

Countries that are more equal in income terms are also richer. But how about the relationship between inequality and economic growth? The classic causal story, based on work by Simon Kuznets,

maintains that there’s an inverted U-shaped relationship over long periods of economic development. As emerging economies grow they initially become less equal as the few with high financial endowments profit off of their ownership of key productive resources, like land. Then, as industrialization evolves, much more of the population has the chance to participate in higher value-added work which reduces inequality. (source)

In this argument, growth determines inequality: first growth drives inequality up, and then it gradually reduces it.

However, this Kuznetsian view has come under fire recently. Thomas Piketty for instance, in his “Capital in the Twenty-First Century“, has criticized Kuznets’ view that inequality will eventually stabilize and subside on its own given increasing growth. According to Piketty, increasing wealth concentration is a likely outcome for the foreseeable future. Kuznets findings were based on a historical anomaly. And indeed, the lines in this graph do not turn downwards to form an inverted U-shape.

Which is why it’s perhaps better to look at the causation in another way: maybe inequality or equality determine growth rather than vice versa. For example, there’s this study arguing that high income inequality is likely to inhibit growth, especially in developing countries.

Inequality inhibits growth, especially in developing countries, because

high income inequality can discourage the evolution of the economic and political institutions associated with accountable government (which in turn enable a market environment conducive to investment and growth); and … high income inequality can undermine the civic and social life that sustains effective collective decision-making, especially in multi-ethnic settings. (source)

This study comes to a similar conclusion. It argues that, in general, more inequality endangers the sustainability of growth. Long consistent spells of economic growth are correlated with low levels of income inequality.

A growth spell in this study is a period of at least five years that begins with an unusual increase in the growth rate and ends with an unusual drop in growth.

It may seem counterintuitive that inequality is strongly associated with less sustained growth. After all, some inequality is essential to the effective functioning of a market economy and the incentives needed for investment and growth … But too much inequality might be destructive to growth. Beyond the risk that inequality may amplify the potential for financial crisis, it may also bring political instability, which can discourage investment. Inequality may make it harder for governments to make difficult but necessary choices in the face of shocks, such as raising taxes or cutting public spending to avoid a debt crisis. Or inequality may reflect poor people’s lack of access to financial services, which gives them fewer opportunities to invest in education and entrepreneurial activity. … [S]ocieties with more equal income distributions have more durable growth. … [A] 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent. (source)

Some additional support for this view comes from the fact that redistributive policies – which are anti-inequality policies – don’t actually harm growth. Redistribution doesn’t help either, according to this graph, but maybe it counteracts the negative effect of inequality on growth given that it counteracts inequality. In that sense, it does help.


11 thoughts on “Income Inequality (30): A Primer on Inequality and Economic Growth

  1. Pardon me, but doesn’t the second graph show that higher inequality is associated with lower rates of GDP growth? Which is also what the paper you used as a source seems to suggest.

    Thank you.

  2. Once upon a time, liberal Democrats understood that there was a tradeoff between efficiency and equality. President Johnson’s chief economist even wrote a book about it. Arthur Okun, Efficiency and Equality: The Big Tradeoff (1976). The new Voodoo Economics preaches that no such tradeoffs are necessary. On the contrary, the New Voodoo Economics preaches that everything that the left wants – primarily more redistribution, more State-mandated equality – not only has no adverse effects on, but is necessary for, efficiency, growth and jobs. No tradeoffs needed here! The New Voodoo Economics is, in other words, a free lunch menu.

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